April 18, 2003 | WebMemo on Taxes
The House and Senate have chosen to provide no more than $550 billion of tax relief over the next ten years, and it is possible that the actual level of tax cuts could fall as low as $350 billion. This undermines the President's goal of boosting economic growth and job creation, but the damage can be minimized if lawmakers focus on tax reforms that improve incentives to engage in productive behavior.
Not all tax cuts are created equal. Providing a $500 annual "rebate" to every taxpayer in the country, for instance, would involve a significant reduction in tax revenue, but it would have no impact on economic growth. Eliminating - or even reducing - the double-tax on dividends, by contrast, would encourage more investment and boost the economy's performance - even though the amount of tax relief might be small compared to a universal tax rebate. It is even possible to use tax policy to boost growth without lowering the overall tax burden. A revenue-neutral flat tax, for instance, significantly would increase national economic output even though taxpayers - as a group - have no extra money in their pockets.
This is why a change in tax policy can be even more important than the size of a tax cut. With this in mind, lawmakers still have an opportunity to put together a tax plan that will boost the economy's performance even though the overall growth package will be smaller than the President requested. But this means that it is especially important to focus on policies that improve incentives to work, save, and invest. Key criteria include:
|Lower Tax Rates||International
|Pro-Job Creation||Encourage Investment|
|Repeal the Double-tax on dividends||Yes||Yes||Yes||Yes|
|Accelerate lower income tax rates||Yes||Yes||Yes||Yes|
|Small business expensing||Yes||Yes||Yes||Yes|
|Accelerate child credit||No||No||No||No|
|Accelerate marriage penalty relief||No||No||No||No|
Economic growth occurs when people work more, save more, and invest more. These are the behaviors that increase national income and boost the nation's wealth. But not all tax cuts improve incentives to engage in productive behavior. With the total amount of tax relief limited, lawmakers will have to be very selective if they intend to encourage additional economic growth.
This does not mean that other tax cuts are misguided. Under a flat tax, for instance, there is a very generous exemption for families and no marriage penalty. As such, there are elements of the President's tax package that are fully consistent with tax reform. In the interest of accurate analysis, however, those policies should be pursued for reasons other than boosting economic growth.
Last but not least, it is worth noting that the actual reduction in tax revenue associated with good tax policy always is smaller than the projections produced by static revenue-estimation models. This is because lower tax rates encourage taxpayers to work more, save more, and invest more. As a result, national income increases, which means that the tax base is concomitantly larger. This does not mean that all "tax cuts pay for themselves." Only in select instances - such as the 1997 capital gains tax rate reduction - will a tax rate reduction generate a big enough increase in taxable income to offset the revenue loss associated with a lower tax rate.
Daniel J. Mitchell, Ph.D., is McKenna Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.